The Total Expense Ratio (TER) indicates the overall cost of operating a scheme or mutual fund. Investors use TER to compare the expenses of one scheme with others similar to it and to understand how these costs affect the returns from the scheme. In mutual funds, TER encompasses all the fees associated with handling, operating, and overseeing the fund, and it is usually presented as a percentage. A good expense ratio depends on various factors, including whether the fund is actively or passively managed. Typically, for actively managed funds, a good expense ratio falls between 0.5% and 0.75%. Ratios above 1.5% are generally considered high. This article aims to explain what TER represents and how it influences investments in mutual funds.
What is a Total Expense Ratio?
The Total Expense Ratio (TER) refers to the fee charged by Asset Management Companies (AMCs) for managing and maintaining a mutual fund scheme. It covers a range of costs, including fund management fees, marketing, distribution, legal, audit, and operating expenses. The TER is expressed as a percentage of the fund's assets under management (AUM) and reflects the annual cost of the service provided.
To calculate the TER, you divide the total expenses of the fund by its average AUM and express it as a percentage. This fee is deducted directly from the fund’s returns, so investors do not pay it separately. Total expense ratio = (Total costs of the scheme during the period / Total Fund Assets) x 100.
Investors essentially pay the TER indirectly, as it is factored into the daily net asset value (NAV) of the fund. This means you don't make separate payments; instead, the cost is automatically adjusted, impacting your overall returns.
How does total expense ratio in mutual funds works?
The fund's management incurs expenses, reflected in the Total Expense Ratio (TER) charged as a percentage of the scheme's total assets. Fund houses declare the Net Asset Value (NAV) after deducting the TER daily, aiding Asset Management Companies (AMCs) in covering management costs.
TER directly impacts your mutual fund returns, where a higher TER implies elevated expenses, consequently affecting fund returns. Consider TER in your evaluation of Mutual Fund performance. For instance, if a scheme has a 20% return and a 2% expense ratio, the net return for the investor is 18%.
Actively managed funds, involving frequent buying and selling to capitalise on market opportunities, generally have a higher TER due to increased transaction and research costs. Conversely, passively managed funds, replicating index performance with infrequent buying and selling, usually have a lower TER, making them an economical choice for investors.
What is a good total expense ratio?
A good total expense ratio (TER) for a mutual fund or investment fund is generally considered to be below 1%. This ratio represents the annual cost of managing the fund, expressed as a percentage of the fund's assets. Lower TERs are preferable as they indicate that a smaller portion of your investment is being consumed by fees, potentially enhancing net returns. Actively managed funds typically have higher TERs compared to passively managed or index funds. A TER under 0.5% is considered excellent, especially for passive funds, while TERs between 0.5% and 1% are reasonable for actively managed funds.
What is the total expense ration formula?
The formula for calculating the expense ratio is as follows:
| TER = (Total Costs Incurred / Total Net Assets) * 100 |
Here, Total Costs refer to all costs incurred by the AMC such as fund manager's fee, marketing and distribution expenses, legal/audit costs, etc. Total Net Assets represent the combined market worth of all the assets, such as stocks and bonds held by the fund on a specific date after deducting all liabilities.
How to Calculate Total Expense Ratio (TER)?
The Total Expense Ratio (TER) is calculated by dividing the total expenses incurred by a mutual fund scheme by its average assets under management (AUM). The formula is:
TER = (Total Fund Expenses / Average AUM) × 100
For example, if a fund incurs ₹10 lakhs in expenses and has an average AUM of Rs. 100 crore, the TER would be:
TER = (Rs. 10,00,000 / Rs. 100,00,00,000) × 100 = 0.10%
This percentage is deducted from the fund’s returns, influencing the net asset value (NAV) and, ultimately, the investor’s earnings.
Major costs that add up to TER in mutual funds
Here are some of the major components of total expense ratio that you should know of:
Management Fee
This constitutes a key component of the total expense ratio. In order to meet the cost of running an office, recruiting staff and managing funds, AMCs deduct this fee from the fund corpus. This is higher for active funds than passive funds.
Distribution Fee
This fee is paid to distributors who sell mutual fund schemes to investors.
Accounting fee
This includes expenses related to maintaining records and reports required by regulators.
12B-1 Charge
This fee is equivalent to the amount spent on advertising each investment fund. It is calculated as a percentage of the fund's net assets and is included in the fund's total cost ratio. The fee is also charged to new investors who allocate funds to the respective mutual fund.
Brokerage Fee
This fee is paid to brokers who execute trades on behalf of mutual funds.
All Other Operating Costs
These include legal fees, audit fees, custodian fees, registrar and transfer agent fees, trustee fees etc.
SEBI limit on TER in mutual funds
Here are the TER Effective from April 1, 2020:
Assets Under Management (AUM) |
Maximum TER as a percentage of daily net assets |
|
TER for Equity funds |
TER for Debt funds |
|
On the first Rs. 500 crore |
2.25% |
2.00% |
On the next Rs. 250 crore |
2.00% |
1.75% |
On the next Rs. 1,250 crore |
1.75% |
1.50% |
On the next Rs. 3,000 crore |
1.60% |
1.35% |
On the next Rs. 5,000 crore |
1.50% |
1.25% |
On the next Rs. 40,000 crore |
TER reduction of 0.05% |
TER reduction of 0.05% |
Above Rs. 50,000 crore |
1.05% |
0.80% |
Mutual funds are now permitted to charge an additional 30 basis points (bps) if the new inflows from retail investors from beyond the top 30 cities (B30) are at least 30% of gross new inflows in the scheme or 15% of the average assets under management (year to date) of the scheme, whichever is higher. This is essentially to encourage inflows into mutual funds from tier-2 and tier-3 cities.
What is the Impact of TER in mutual funds on returns?
The TER can have a significant impact on your returns from mutual fund investments. A higher expense ratio means that a larger portion of your returns will be deducted as fees, thereby reducing your overall returns. On the other hand, a lower expense ratio can help you maximise your returns.
Significance of expense ratio in mutual funds
Estimating investment costs
The expense ratio in mutual funds assists investors in understanding the amount they pay for fund management. As the investment value increases, the fund's expense ratio also increases proportionally. This insight allows investors to anticipate changes in their investment value.
Evaluating direct plans
Direct plans typically offer lower expense ratios compared to regular plans due to the absence of third-party involvement in the investment process. This affordability prompts investors to consider more cost-effective alternatives. However, it is essential to evaluate other aspects such as fund performance and risk before finalising investment decisions.
Assessing impact on returns
A higher expense ratio in mutual funds reduces investors' returns on investment over time. Therefore, being aware of the expense ratio in advance helps investors understand the potential erosion of their returns. This awareness enables investors to align their investment goals with their choice of investment instrument more effectively, streamlining the overall investment process.
Why is TER frequently changed by fund houses?
India’s regulatory body for the mutual fund industry, the Securities Exchange Board of India (SEBI), has implemented guidelines governing the maximum expense ratio charged to investors by Fund Houses.
India's mutual fund industry regulator, the Securities and Exchange Board of India (SEBI), has established specific guidelines on the maximum expense ratio that fund houses can charge to mutual fund investors. Fund houses adjust the TER for two primary reasons: changes in Assets Under Management (AUM) and to maintain competitiveness in the market. The current expense ratio limits for various types of mutual funds are as follows:
Assets under management slabs |
TER limits for equity-oriented schemes |
TER limits for other mutual fund schemes (excluding Index Funds, ETFs, and Fund of Funds) |
0 to Rs. 500 crore |
2.25% |
2.00% |
Rs. 500 crore – Rs. 750 crore |
2.00% |
1.75% |
Rs. 750 crore – Rs. 2,000 crore |
1.75% |
1.50% |
Rs. 2,000 crore – Rs. 5,000 crore |
1.60% |
1.35% |
Rs. 5,000 crore – Rs. 10,000 crore |
1.50% |
1.25% |
Rs. 10,000 crore – Rs. 50,000 crore |
TER decreases by 0.05% for each AUM increase of Rs. 5,000 crore or part thereof |
TER decreases by 0.05% for each AUM increase of Rs. 5,000 crore or part thereof |
Over Rs. 50,000 crore |
1.05% |
0.80% |
How changes in AUM impact TER of mutual funds?
Assets Under Management (AUM) refers to the total value of assets a mutual fund holds in its portfolio. This figure plays a crucial role in determining the Total Expense Ratio (TER), as per guidelines set by SEBI. The higher the AUM, the more efficiently a fund can spread out its operational costs. Consequently, SEBI mandates that the expense ratio charged by mutual funds is linked to their AUM, with larger funds required to have a lower TER.
When the AUM of a mutual fund increases, the fund can distribute its fixed costs over a larger asset base. This results in a decrease in the TER, making the fund more cost-efficient for investors. Conversely, if a fund's AUM decreases, its TER may rise since the same costs are spread across fewer assets, leading to a higher percentage of fees relative to the fund's size.
In essence, a growing AUM benefits investors by reducing the proportion of fees they pay, thereby improving returns. However, a shrinking AUM can lead to an increase in TER, negatively impacting the overall profitability of the investment. Understanding the relationship between AUM and TER is essential for evaluating a mutual fund's cost-effectiveness.
How TER change to stay competitive?
India's mutual fund sector is highly competitive, with numerous fund houses contending for investor capital. In such a crowded market, a fund's performance becomes a key differentiating factor. Investors closely monitor returns, and if a mutual fund consistently underperforms, they may choose to switch to a better-performing scheme. As the expenses associated with managing a mutual fund influence its overall returns, the Total Expense Ratio (TER) becomes a critical factor that fund houses carefully consider.
A high TER can significantly impact a fund's net returns, making it less attractive to investors. This is particularly evident when comparing similar funds within the same category. If a mutual fund has a higher TER than its peers but doesn't deliver superior performance, it may struggle to retain or attract investors. Over time, this can lead to stagnation or even negative growth in its Assets Under Management (AUM), as investors flock to more cost-effective alternatives.
Recognising this, fund houses strategically set their TER to balance profitability and competitiveness. They aim to keep the expense ratio at a level that covers operational costs while remaining appealing to investors. Too high a TER risks deterring potential investors, while a lower TER can help enhance returns, boost AUM, and attract more capital.
In such a competitive landscape, maintaining a reasonable TER is essential for fund houses to stay competitive and ensure sustainable growth. It’s a fine balance that requires constant evaluation of fund performance, costs, and investor expectations.
Things to keep in mind about the TER
Here are some important things to keep in mind about TER:
Definition
TER represents the total annual costs of managing and operating a fund, expressed as a percentage of its total assets. It includes management fees, administrative expenses, operating costs, and other miscellaneous charges.
Comparison tool
TER serves as a useful tool for comparing the cost-efficiency of different investment funds. Lower TERs generally indicate lower overall expenses, which can potentially lead to higher returns for investors.
Impact on returns
High TERs can significantly eat into your investment returns over time. Even seemingly small differences in TERs can add up to substantial amounts over the long term, affecting the compounding of your investments.
Transparency
Fund providers are required to disclose the TER of their funds, allowing investors to make informed decisions about where to allocate their money. Transparent disclosure ensures investors understand the true cost of investing in a particular fund.
Factors affecting TER
TER can vary depending on various factors such as the fund's investment strategy, asset class, size, and geographical location. Actively managed funds typically have higher TERs compared to passively managed index funds or ETFs.
Hidden costs
While TER provides a good overview of a fund's expenses, it may not capture all costs associated with investing. Investors should also consider other potential fees such as trading costs, performance fees, and taxes, which can impact overall returns.
Importance of Review
Investors should regularly review the TER of their investment funds to ensure they remain cost-effective relative to their performance and compared to alternative options in the market.
Long-Term Perspective
When evaluating TER, it's essential to take a long-term perspective. While lower expenses are generally favorable, investors should also consider other factors such as the fund's performance, investment objectives, and risk profile.
By keeping these points in mind, investors can make more informed decisions when selecting investment funds and better understand the implications of TER on their investment returns.
Conclusion
In conclusion, understanding the Total Expense Ratio (TER) is crucial when investing in mutual funds. It helps you identify the costs associated with investing in a particular scheme and its impact on your returns. By comparing TERs across different schemes and choosing those with lower ratios, you can maximise your returns from mutual fund investments.
